Small-Cap Strength Broadens In 3Q 2016

Chairman Chuck Royce and Co-CIO Francis Gannon look at broadening small-cap strength in the volatile third quarter, discuss why value should continue to lead in the current cycle, and explain where they are finding opportunities.

Small-Cap Strength

Do you think the resurgence for growth stocks in Q3 signals a resumption of small cap growth leadership?

Chuck Royce: I don’t. First, it was a powerful quarter for small-caps as a whole, even after accounting for the additional volatility caused by Deutsch Bank’s troubles at the end of the quarter. Classic value and quality stocks lagged, but their returns were strong on an absolute basis.

In fact, the third quarter was the strongest for the Russell 2000 so far in 2016. I’m not entirely sure why, but investors were definitely willing to take a little more risk and look at more speculative areas in the third quarter. In any event, I think the power of reversion to the mean—which is a truly formidable force, maybe the most powerful in the markets—will keep value in the leadership seat for the rest of the current small-cap cycle.

[drizzle]

Francis Gannon: It looks very much like a catch-up quarter. Most of those areas that were lagging through the end of June all enjoyed a strong third quarter. Micro-caps, growth stocks, and low-quality companies—based on low or no earnings, profitability, and returns on invested capital—were the leaders for the quarter but were still behind year-to-date.

What do you think broadening small-cap strength says about where we are in the current small-cap cycle?

On the other hand, there have been some quietly encouraging signs of renewed growth in China and Brazil among the larger emerging market economies. More important, the U.S. economy continues to muddle through and look far better than any of its competitors. Housing, employment, and auto sales all remain brisk, consumer confidence is solid, and the dollar has gone from a rapid rise to flattening.

Of course, we also have a highly polarized election coming up in November, and investors are still pulling money out of equity vehicles at a pretty rapid clip. This is consistent with the bearish perspective we’ve heard from clients and that seems increasingly prevalent in spite of how well most U.S. stocks have done since February.

With all of this conflicting information, it’s harder than usual to get a sense of where we are. I would say that, even accounting for the pervasive negativity about stocks and the economy, small-cap valuations don’t look that rich to me, and I don’t see any of the familiar signs of a market top.

Having said that, small-caps also look overdue for a correction—say in the 8-15% range— since it’s been more than seven months since we’ve had a downturn.

Intra-cycle corrections are a common occurrence, and we’d look to invest as prices fell, just as we’ve always done. So while a pullback looks likely, I don’t believe it would be a long-term negative development.

When you look at history, you find that what works best just before a bear market, which in the last cycle was the biopharma group, is not what works in the next bull phase. So even with all of the uncertainty we currently face, I feel confident that we won’t see the kind of overly narrow leadership we saw in 2015. I think this is supported by the widespread strength in small-cap returns year-to-date.

With the Russell 2000 Index up 32.6% off the 2/11/16 low, what are your expectations for small-cap returns over the next few years?

Chuck: As happy as we are with the way the current cycle is shaping up, I still think that annualized returns for three- and five-year periods are likely to be low—probably in the high single digits. The period prior to last June’s peak for the Russell 2000 was so strong that it’s hard for me to see a similarly robust period for small-caps going forward. But I think that’s all right because I also believe that returns at those levels will be attractive relative to what investors can expect elsewhere.

You have typically avoided exposure to defensive sectors, many of which, other than health care, were notably weak in Q3. Are you seeing opportunities in any of those areas?

Frank: We saw a limited number of opportunities in Health Care earlier in the year, both in bio-pharma and in less speculative industries such as health care equipment & supplies and health care providers & services.

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Similarly, as stock prices in Consumer Staples slipped in the third quarter, we saw what we thought were a few attractive bargains. (Our strong quality and low leverage preferences have generally kept us out of Utilities.) So while our overall exposure to defensive sectors remains low, we have been looking carefully on a stock-by-stock basis in both Health Care and Staples for companies that fit our different small-cap approaches.

Your own and many other Royce portfolios have overweights in Industrials. Do you think those stocks can outperform without a cyclical upturn?

Chuck: We do. A cyclical upturn would obviously be a significant positive—and it’s not out of the question considering the rebound for many commodity prices. However, there are other positives for these companies outside a period of stronger top-line growth. For example, many industrial businesses were so wildly oversold in 2015 and into the beginning of this year that, even with their notable recoveries since the February trough, their valuations still look reasonable to us.

In addition, the slackening strength of the dollar and easier quarter-over-quarter earnings comparisons should make them even more attractive to investors.

Finally, we think it’s likely that the economy will continue to muddle through, which should help reasonably valued businesses with a history of effective execution—and that profile fits nicely with the kinds of businesses that we hold in many Royce portfolios.

What areas of the Financials sector have you been most active in over the last several months?

Chuck:We’ve been focusing on alternative asset managers because we think their business models and earnings patterns are poorly understood and highly promising. This means that we’re finding attractively valued companies in that space, including companies involved in private equity, venture capital, alternative investment vehicles, and asset-light, non-bank lenders. Many of these investments are long-term ideas—but we believe strongly that they will be leading growth areas within Financials over the next several years.

What stands out as most notable from your recent meetings with company management teams?

Frank: It hasn’t changed appreciably, which we think is a good sign. The majority remain very cautious, which is not surprising considering the risks and uncertainties that we’re seeing.

Do you still see a Fed rate hike as ultimately a positive sign for the economy and capital markets?

Chuck: Absolutely. It may be a contrarian view, at least among equity managers, but I’m unequivocal in my conviction that higher rates are the last, necessary step in the long process of normalization that began with the cessation of quantitative easing almost two years ago.

As much as no one loves the long, slow recovery we’re having, it’s important to stress that the economy has nonetheless been growing for several years now—it’s no longer in the fragile state it was during the Financial Crisis, far from it. So I think the Fed needs to act in a way that’s consistent with a functional economy.